Talking to my granduncle is like reading a classic all over again. Every time you read a classic, you get to learn a new manifestation of life. Similarly, my granduncle tells me the same stories of his youth every time I sit with him, and each time I learn a new thing from his old stories.
One of his regular stories is about how in his youth, he could buy five kilogramme of Desi Ghee for just four rupees; and how he could live a decent life with royal paycheck of Rs 42 that the Queen Victoria would pay him.
The unconventional monetary policies followed in the past one decade have brought about a paradigm shift in global financial markets. The new conditions, popularly known as "New Normal", indicate that there is broader consensus on lower economic growth for longer. New Normal also assumes that primary effort of policy makers should be in protecting the status quo — market stability with somewhat positive real growth, employment with static or lower real wages, focus on fiscal prudence, emphasis on cost savings through productivity gains, lower cost of capital and hence higher asset prices, etc.
These assumptions necessitate a change in the valuation model for various assets, especially financial assets.
In fact, we have indeed witnessed a change in valuation bands in equity, bonds, commodities and currencies.
Global equities are trading close to their highest valuations. Bond yields are persisting in the lower orbits, even for most troubled economies in peripheral Europe. Commodities are the cheapest relative to equities in the last five decades. JPY is being accepted as best safe haven when BoJ balance sheet is bulging from all sides.
Back home, we have already seen some equity research reports talking about PEG (price to growth) as preferred mode of valuation against the conventional PER (price to earnings ratio). The last time we heard about PEG was at the height of dotcom bubble in 1999-2000. An intense debate is raging in the market about the "bubble in quality" and "opportunity in growth"
In my school, we always learned that the equity investment should be valued in terms of return from business we are investing in, and not the price of stock in the market. Return on capital employed (ROCE), dividend yield (DY) and price to earnings (PER) were three primary criteria for making a buy decision.
We were taught that the return on the investment in publically traded equity is a function of 3 factors (a) earnings growth; (b) changes in price earnings (PE) ratio and (c) dividend.
The earnings growth is a function of multiple factors, e.g., (a) capacity (production capability); (b) demand environment (market leadership); (c) competitive landscape (pricing power, cost advantage); (d) innovation and technology advantage; and (e) resource availability (raw material, labour, capital, managerial bandwidth etc.).
Price to earnings ratio
The price earnings ratio (PER), one of the most popular equity valuation criteria, is the ratio between the earnings of a company and its market value. It broadly signifies that at the current rate of earnings how many years it will take for the company to add the value which an investor is paying today.
Principally, an acceptable PER for a company's stock is defined by (a) the return on equity (RoE) a company is able to generate on sustainable basis and (b) the growth rate of earnings that could be achieved on sustainable basis. A company that could generate higher RoE consistently and is likely to grow faster, should be assigned a higher PER as compared to the ones which generate lower RoE or has low or highly cyclical earnings growth.A rise in PER, if not commensurate with the rise in earnings profile needs deeper scrutiny.
Sometimes, the rise in PER occurs due to correction in anomalies (undervaluation) of the past. This is a welcome move. Sometimes, PER changes (re-rates) due to relative forces, e.g., rise of PER in comparable foreign markets or change in return profile of alternative assets like bonds, gold, real estate etc. This is usually unsustainable and therefore a short term phenomenon. Many times, demand-supply mismatch in publically traded equities also drives re-rating of PER (excess liquidity chasing few stocks and vice versa). This is again usually a short term phenomenon. Dividend yield
Sustainable rise in dividend yield is generally a sign of stable profitability growth (P&L improvement) and strong financial position (B/S improvement) and stronger cash flows. In some cases, however, it could reflect stagnation in growth and/or inability of the management to generate RoE that is significantly higher than the risk free rate of return.
However, what I learned in school no longer seems to be the case. A variety of new or lesser-used valuation methods are being used to justify the price. It seems that price has become the primary driver of valuation method rather than the earnings.
Coming back to my granduncle story - I always fail to understand why he always laments the inflation and rising cost of life. In his youth days, he spent 10 percent of his monthly income on Desi Ghee. Today, the person holding his position in the government spends just 1.5 percent of his salary on the same 5kg of Desi Ghee. Even if we consider his earnings, he can buy 5kg of Desi Ghee with less than 6 percent of his pension.
The learning in this for me is that we are bound to get distorted results leading to a fuzzy narrative if we operate on the fractions improperly. We must move both the numerator and the denominator in equal proportion to get correct results!
Rejecting the valuations under the New Normal without juxtaposing it with other parameters might distort our vision.
In my view:
(a) The corporate earnings growth is closely correlated to ‘nominal GDP growth’ of the economy. With inflation in declining trend, most estimates forecast the nominal GDP to sustain at lower levels in next few year at the least. Moreover, the RBI has also admitted the investment climate in the country is still damp and there are little indications of this improving in next few quarters. Therefore, the average earnings growth in next 3years may remain close to the long term average.
(b) Given the low growth, stressed balance sheets, policy risk, uncertainty over continuation of global flows and fragile global economic conditions, there is little probability of any noteworthy re-rating of Indian markets in the next 12 months at the least.
Under these circumstances, it may not be pragmatic to expect significantly higher return in next 24 months as compared to the past 5-year average. For records, Nifty 500 yielded 7.7 percent CAGR in past 5 years (November 2014 to November 2019) and the return from Nifty 50 has been a tad lower at 7.6 percent CAGR. Anything higher than 11-12 percent CAGR (including dividend yield of 1.5 percent) would be a bonus for which you may like to thank your stars and blessings of elders.
Vijay Kumar Gaba explores the treasure you know as India, and shares his experiences and observations about social, economic and cultural events and conditions. He contributes his pennies to the society as Director, Equal India Foundation. Read his columns